Expense ratio is one parameter that beginners must first watch in any mutual fund.
Higher expense ratio is a cause of concern for investors.
Expense ratio of 2.45% means, for every $100 invested, $2.45 goes to cover the mutual funds overheads.
This money never gets invested.
So from investors point of view, expense ratio indicates the wastage of their invested money.
Though one can never reduce this wastage to zero, but the minimum is the expense ratio the better.
Some best performing funds in the world keeps their expense ratio below 2%.
From Mutual Funds point of view as well, higher expense ratio is not what they want to see.
Because, to compensate high expense they need to take bigger risks.
That makes their returns very volatile.
Very volatile portfolio will not attract many investors.
Expense Ratio – Transparency
Good fund houses are very transparent about their expenses.
They explain their costing structure to their investors before committing them into their funds.
But not all mutual funds are so genuine.
It is duty of investors to digg deep into the cost structures of mutual funds on their own.
A typical mutual fund will have the following expense:
The biggest cost for any mutual fund is Investment management & Advisory fees.
This includes the compensation paid to the fund manager.
On an average this cost is in tune of 0.5 to 1% of total AUM.
Mutual funds also spends money to manage its administrative costs.
This cost includes:
- Audit fees,
- Fund transfer cost,
- Customer statements,
- Investors education,
- Brokerage and transaction costs,
- Advertisement fees etc.
In short we can say that all these costs are incurred by a mutual fund to run it profitably.
Investors are not charged extra for these costs. Instead it is charged to the funds portfolio itself.
Suppose a mutual fund collected money from investors worth Rs 500 Crore.
After one year the asset value rose from Rs 500 crore to Rs 565 Crore.
In this case the annualised return will be 13%.
Suppose this fund has expense ratio of 2.4%.
In this case it will charge 2.4% on Rs 565 Crore (Rs 13.6 Crore).
After charging this cost, net value of portfolio is reduced from Rs 565 Crore to Rs 551.4 Crore.
It means, annualised return for investor will be 10.28% (instead of 13%)
How to know if mutual fund is charging expenses correctly to the portfolio?
Well, for a normal investors, mutual funds will never show their calculations.
But to clear the air, regulators has put a cap on maximum costs that can be charged to a portfolio.
- For equity linked funds, maximum charge can be 2.5%
- For equity linked funds, maximum charge can be 2.25%
In case cost of any mutual fund is higher that the specified limits, fund house must bear the differential cost themselves.